Study Notes: The Recording of Adjustments in Ledger Accounts

Hello future Accountants! This chapter is incredibly important. You’ve already learned how to record everyday transactions, but sometimes, at the end of the year, we need to ‘tidy up’ the books to make sure our profit figure is 100% accurate. This process of tidying up is called making adjustments.

Don't worry if this seems tricky at first—we are just moving items around to ensure they are recorded in the correct accounting period. Let’s dive in!

1. Why Do We Need Adjustments? The Accounting Concepts

The purpose of adjustments is simple: to ensure our financial statements follow key accounting rules. The two most important concepts driving adjustments are:

i. The Matching Principle (or Accruals Concept)

  • The rule states that expenses must be matched against the revenue they helped generate in the same accounting period.
  • Analogy: If you earn £500 selling lemonade in June, you must include the cost of the lemons (say, £50) in June’s expenses. You can’t wait until July to record the cost.

ii. The Prudence Concept

  • This principle says we should always be cautious. We must not overstate assets (make them look bigger than they are) or overstate profits.
  • When in doubt, always choose the option that leads to lower profit or lower asset values. This concept is key for recording depreciation and potential bad debts.

Quick Key Takeaway: Adjustments are essential to follow the Matching and Prudence concepts, giving us a 'true and fair view' of the business’s performance.

2. Adjusting for Non-Current Assets: Depreciation

What is Depreciation?

Most assets we use for a long time (like machinery, vehicles, and furniture – called Non-Current Assets) lose value over time due to wear, tear, or obsolescence (going out of date). This loss in value is an expense called Depreciation.

Did you know? Depreciation is a crucial adjustment because it ensures the cost of the asset is spread out over its useful life, matching the expense to the years the asset generated revenue.

The Double Entry for Recording Depreciation

There are two parts to recording depreciation in the ledger: the expense and the accumulated amount.

Step 1: Recording the Expense (Impact on Profit)

  • We need to record depreciation as an expense in the Income Statement (to reduce profit).
  • The entry is:
    Debit: Depreciation Expense Account (Increases the expense)
    Credit: Accumulated Depreciation Account (This is the total wear and tear so far)

Step 2: Recording Accumulated Depreciation (Impact on SFP)

  • The Accumulated Depreciation account is a special type of credit account. It doesn't reduce the asset account itself (e.g., the Vehicles account), but it is shown as a deduction from the asset on the Statement of Financial Position (SFP).
  • Book Value (or Net Book Value, NBV) is calculated as:
    \( \text{Cost of Asset} - \text{Accumulated Depreciation} = \text{NBV} \)

Common Mistake to Avoid: DO NOT credit the Non-Current Asset account (e.g., Machinery) directly when recording depreciation. You must credit the separate Accumulated Depreciation account.

3. Adjusting for Receivables: Bad and Doubtful Debts

Trade Receivables (also known as Debtors) are customers who bought goods on credit and owe the business money. Unfortunately, sometimes they don't pay.

i. Writing Off Bad Debts

A Bad Debt is an amount that is definitely uncollectable (e.g., the customer has gone bankrupt). Under the Prudence Concept, we must remove this debt from our books and record it as an expense.

The Double Entry:

  • We must reduce the asset (Trade Receivables) and record the loss (Bad Debt Expense).
  • Debit: Bad Debt Expense Account (Increases the expense, reduces profit)
  • Credit: Trade Receivables Account (Reduces the asset owed to us)
ii. Provision for Doubtful Debts

A Doubtful Debt is an amount we *suspect* we might not collect in the future, even if the customer hasn't declared bankruptcy yet.

Prudence tells us we should estimate this potential loss and create a Provision for Doubtful Debts. This is an estimate, not a certain loss.

The Double Entry (Recording the Increase in Provision):

  • If the provision needs to increase (meaning we expect more losses), we record it as an expense:
  • Debit: Income Statement (or an Expense account)
  • Credit: Provision for Doubtful Debts Account

This provision acts similarly to Accumulated Depreciation: it’s a negative adjustment shown against the Trade Receivables figure in the SFP.

Trick for remembering the impact: If the provision increases, it is a loss (Debit Income Statement). If the provision decreases, it is a gain (Credit Income Statement).

4. Adjusting for Timing: Accruals and Prepayments

These adjustments are vital for adhering to the Matching Principle. They ensure that all revenue earned and all expenses incurred are recorded in the correct period, regardless of when the cash was paid or received.

i. Accruals (Expenses Owed but Not Yet Paid)

An Accrued Expense means the business has used the service or incurred the cost, but has not yet received or paid the bill by the end of the financial year.

  • Example: You used the office heating throughout December, but the bill won't arrive until January. December is in this financial year, so the expense must be recorded now.
  • Impact: This creates a Current Liability (we owe the money).
  • Double Entry:
    Debit: Expense Account (e.g., Heating Expense, increases the expense for this year)
    Credit: Accruals Account (Creates a liability on the SFP)
ii. Prepayments (Expenses Paid but Not Yet Used)

A Prepaid Expense means the business has paid for an expense in advance, and some of the benefit relates to the next financial year.

  • Example: You pay £1,200 for 12 months of insurance on December 1st. If your year end is December 31st, 11 months (£1,100) are for the next year. You have 'prepaid' those 11 months.
  • Impact: This creates a Current Asset (we own the benefit of the service).
  • Double Entry:
    Debit: Prepayments Account (Creates an asset on the SFP)
    Credit: Expense Account (e.g., Insurance Expense, reduces the expense for this year)

Summary Aid:
Accrual = Add to Expense, creates Liability (Owe)
Prepayment = Pull from Expense, creates Asset (Benefit Owned)

5. Adjusting for Inventory (Closing Stock Valuation)

When preparing the final accounts, the value of goods left unsold at the end of the year (Closing Inventory or Closing Stock) must be accurately determined.

Inventory Valuation Principle

The value of closing inventory must follow the Prudence Concept. It must be valued at the Lower of Cost and Net Realisable Value (NRV).

  • Cost: The original price paid for the goods.
  • Net Realisable Value (NRV): The estimated selling price minus any selling costs.

We use the lower figure to prevent overstating the value of our assets or potential future profit.

Recording Closing Inventory as an Adjustment

The value of Closing Inventory is crucial because it affects the Cost of Sales calculation and is shown as a Current Asset on the SFP.

When the Closing Inventory value is determined, it is recorded in the ledger by transferring it:

  • Debit: Inventory Account (This records the asset value on the SFP)
  • Credit: Income Statement Account (This reduces the Cost of Sales, thereby increasing the Gross Profit)

Final Key Takeaway: All these adjustments move money from temporary accounts (expenses, income) to permanent accounts (assets, liabilities) to make sure the profit shown in the Income Statement is correct for the period, and the assets/liabilities shown in the SFP are correct at the end date.